Micro Cap Flash 2015 Q2

“Genius is nothing but a great aptitude for patience.“
— George-Louis de Buffon

STEADY IMPROVEMENT CONTINUES FOR 2015

The Uniplan Micro Cap Portfolio employs a low-turnover, high-conviction strategy designed to offer investors a quality alternative to private equity. It is designed to earn a similar unlevered return while providing daily liquidity. The core investment thesis is focused on companies with little or no balance sheet leverage, trading at a low multiple of cash flow or EBITDA, and having meaningful smart money activity in the form of insider buying, or 13G/13D activity.

During 2013, the patient micro cap investor was rewarded with a 50%+ for staying in the game. In 2014 micro caps essentially marked time. For the year to-date 2015, investors are off to a steadily improving start in a difficult environment.

For the year-to-date period ended July 24, 2015 the preliminary estimated investment results for the micro-cap portfolio are as follows:

Based on a study of several indices moves so far this year it appears that investors are showing little discernment between large cap, mid-cap and small cap stocks. Consider the YTD (July 24, 2015) performances of the following: the Large Cap Russell 1000 +2.41%; the Russell Mid Cap +1.67%; the Small Cap Russell 2000 +2.46 and finally, the broader based Russell 3000 +2.4%. However, if the Uniplan Micro Cap portfolio gain of 7.76% is an indication, there is a strong appetite for high-quality, US based, quality micro-cap stocks which is what Uniplan strives to invest in.

So, what might distinguish our current micro cap holdings from other micro caps as well as the broader market? In reviewing our attribution data, there are several thematic items that stand out. First, the Uniplan micro cap holdings have virtually no direct exposure to the energy sector which has lost about -24% for the YTD. In addition, the portfolio is underweight the financial sector at 12% exposure vs. 28% weight in the Russell micro cap index.

We believe small financial company stocks have underperformed due to broad based concerns over rising interest rates which generally hurt most financial companies except banks which tend to show improving net interest margins in a rising rate environment. Our portfolio is historically underweight financial stocks due to the relatively high level of debt leverage that is used on the balance sheets of those companies. This removes them from consideration early in our screening process which seeks to avoid too much debt on company balance sheets.

Finally, stock selection has also been a large contributor to portfolio performance, with selection contributing about 400bps to our overall portfolio returns for the year-to-date. The areas where stock selection has made the largest contribution have been in the technology and health care sectors contributing about +490bps and +320bps respectively with these sectors representing about 38% of the overall portfolio. The area where stock selection has been the weakest has been materials and telecom, detracting by about -450bps and -280bps respectively; however these sectors have less benchmark and portfolio weighting than the contributing sectors and represent about 11% of the total portfolio.

THE STATE OF M&A

The most recent M&A activity has been focused in the mega cap space. Anthem announced that it plans to acquire Cigna in a deal valued at $54.2 billion. If successful, the merger will create the largest insurer in the country. Roche, Johnson & Johnson, Biogen Idec and Shire have each announced deals in the pharma space. Berkshire Hathaway’s purchase of Heinz then Kraft were surprise mega mergers in the consumer segment. There have been several multi-billion dollar deals in the MLP sector. The common thread is that these are MEGA deals. What we have yet to see is the impact of the estimated $750 billion in private equity might have on micro caps. The issue is whether the market conditions that have fueled mega merger activity will push down to micro cap M&A in 2015.

The drivers behind M&A activity have been the abundance of corporate cash available to be deployed and the reemergence of reasonably priced bank financing for the deal community. Additionally, while less applicable to the micro-cap market, slow corporate earnings growth downstream of the recession has forced big corporations to seek growth externally rather than focus on organic increases in revenue.

Pitchbook, a supplier of data to the Private Equity and Venture Capital world, suggests that Private Equity has approximately $750 billion of “dry powder” available for deal-making through recent equity raises, along with a large portfolio of pre 2007 seasoned companies that will soon result in additional liquidity. The availability of debt continues to improve and be more accessible which is helping to support valuations. The Wall Street Journal recently reported that in 2014, purchase price multiples reached 2007 levels, the previous bell-weather valuation year. Like that pre-recession peak, multiples are being driven by higher levels of leverage, with debt available at over five times EBITDA in good cash flow situations. These market factors will continue to support 2015 as another record year in mergers & acquisitions. E&Y’s recently published US Capital Confidence Barometer suggests that the robust market will continue for the near term. An all-time high of 80% of E&Y’s respondents believe that the M&A market will improve in 2015. The vast majority of deal-makers asked, are evaluating more than one deal and almost half were considering more than five potential transactions.

In addition, E&Y reports that the middle market will benefit from this bullish outlook; this should have a positive impact on the micro-cap space as more money is deployed in the middle market which is the sweet spot for micro cap transactions. The bid-ask spread of price expectation has significantly shifted toward middle market deals over the past 12 – 18 months. As mentioned, until recently M&A markets have been led by large cap transactions, followed by a period of focus on the middle market as acquirers fully digest their large acquisitions and reshape their future plans. So far, 2015 is on course to meet this trend.

THEMATIC PORTFOLIO

As we detailed in our year end Flash Report, we viewed 2014 as a transition year for both micro caps and the broader economy. As such we undertook a rigorous portfolio review with the idea of reducing risk and harvesting some long term gains to prepare for a reallocation process.

The year started with a high level of economic and market uncertainty. Micro Caps seemed to show no clear broad thematic long-arc paradigms outside of increasing M&A activity which we expected due to the large volumes of private equity and relaxing underwriting standards on debt. We created a list of our “Top Ten Thematic Ideas” which we use as a macro framework for idea generation among companies that meet our value screening criteria. The top ten themes are as follows (all data as of the close 7/24/2015):

1.	Genomic medicine will revolutionize the way we look at and treat illness. Our top portfolio pick in this thematic space is Trinity Biotech (TRIB) yield 1.2% up +6.8% for the YTD; a maker of genetic lab tests primarily in cancer related areas.
2.	Shale gas could, within the next decade, change the dynamics of world energy and make the US a net exporter of energy. Our favorite derivative play on this theme is Gorman Rupp (GRC) yield 1.6% down -19.5% YTD; a world class maker of specialty pumps which has declined on weaker energy prices.
3.	Military spending will shift to fast deployment and human intelligence vs. large weapons systems and multi-billion dollar platforms. Our top pick in this area is American Science and Engineering (ASEI) yield 4.5% down -12.8% YTD; a maker of scanning and screening equipment used in transportation.
4.	Labor costs will continue to rise around the globe. The world is flat and substitution of capital for labor will accelerate. Robotics, smart machine tools, high skilled model making and JIT manufacturing, mid-tech precision systems will all benefit from this trend. Our top portfolio idea in this area is Integrated Silicon Solutions (ISSI) yield 1.1% up +35.5% YTD; a maker of chips and automated control systems. It must be noted that the significant price rise was primarily due to ISSI being acquired and this deal provides an excellent example of our M&A thesis. ISSI, a niche microchip maker with low debt, little Street coverage and solid earnings growth, was the subject of a pitched battle between Cypress Semiconductor and Uphill Investment, a Chinese concern. Uphill ultimately won in July with a $23 cash offer.
5.	Food inflation will become a growing issue as billions around the globe move from grain to protein consumption as standards of living rise. Farmland, ag-business, fertilizer, GMO plants, non-point pollution control – genetics of plants and cells are all opportunities. Our best performing name in this area is Park City Group (PCYG) yield .08% up + 35.1% YTD; a maker of food safety and quality control tracking systems for the food industry.
6.	Water will continue to be the next looming problem for developing and emerging economies. It’s scarce and expensive and that’s not going to change—water technologies will be increasingly important. Our top pick in this area is Consolidated Water (CWCO) yield 2.4% up + 17.5% YTD; an owner and builder of water desalination plants and systems.
7.	Retail and the internet – those who successfully integrate a web and bricks and mortar strategy will win the race—but the way consumers shop will continue to stress the retail paradigm. Our favorite name here is Petmed Express (PETS) yield 4.2% up +20.9% YTD; a multi-channel distributor and retailer of veterinary medicines and pet supplies.
8.	Education of a lost generation will become front-and-center as college becomes unaffordable and student performance continues to slump. Systems to deliver effective low cost curriculum and training will become of focus as the current education system slowly decays. A name we like in this thematic area is Chegg Company (CHGG) yield 0.0% up +16.5% YTD; a producer of internet based training and college course and study materials.
9.	New models of eldercare will become a growth business as the world population ages and need for care of the aging increases in a world short on skilled labor. A derivative play on this theme is Physicians Realty (DOC) yield 5.6% up +5.4% YTD; an owner of healthcare properties strategically located at or near major hospitals and nursing homes.
10.	SAAS (Software as a Service) will continue to emerge as the new paradigm and drive demand for data related storage and bandwidth particularly when coupled with the growth in mobile computing. A play in this area is Alliance Fiber Optic (AFOP) yield 0.7% up approximately 45.8% YTD; a manufacturer, engineer and installer of fiber optic cable and systems.

These thematic holdings coupled with some special situation names comprise most of our core holdings and are generally related in some manner to the themes listed above.

PORTFOLIO DEAL ACTIVITY

We have recently seen acceleration in M&A within our portfolio, losing four companies to near term deal activity. Two additional companies which were on our watch list as possible investment candidates were also involved in transactions thus limiting some of our opportunities. This compares with three deals in the portfolio during 2013; up from one deal in 2012 and two during 2011 but still below the average of five deals annually which was the norm through 2010.

Recent Uniplan Micro Cap Portfolio Deal Activity

(Source: Uniplan Investment Counsel, Inc.; Baseline)

The investment banking community has not missed the fact that the collective cash on the balance sheet of the American industrial complex has reached an all-time high. As measured by net debt to equity, balance sheet leverage for non-financial companies is currently running at below 15%, a level unseen since the late 1950’s. And, according to Thomson Reuters’ data, companies around the world held almost $9 trillion of cash and equivalents on their balance sheets at the end of 2014; that is more than twice the level of 10 years ago. And capital expenditure relative to sales is at a 22 year low while the average age of corporate fixed assets and equipment has been stretched to 14 years from pre-crisis norms of about 9 years.

In the large-cap world, some of this money has been returned to shareholders in the form of share buybacks and dividends often times with the encouragement of dissident shareholders and corporate activists. In micro cap land, there have been very few share repurchases, but dividends and special dividends have become far more widespread. As of July 24, the average dividend yield in the micro-cap portfolio stood at around 1.92% which is an encouraging positive indicator of valuation given the low interest rate environment.

CONCLUSION

With corporate cash at an all-time high, we believe any combination of improved earnings and economic outlook will give buyers the confidence to more vigorously step back into the M&A Market. We anticipate there will be continued volatility during the balance of 2015, as factors such as the global economic outlook and the strong US Dollar continue to cause uncertainties around earnings and economic growth. But, valuations remain attractive for many micro cap companies and as a contrary indicator, the lack of investor interest in the micro-cap space seems to be nearly universal. We continue to position in new opportunities within the portfolio that appear to have good long term value. Thus, we continue our deployment of portfolio funds with a focus on our thematic framework and increasing the quality of names within the portfolio with dividend yields as an added bonus if available in good quality micro cap opportunities.

Richard Imperiale
Portfolio Manager

Information: 1. Uniplan Investment Counsel is a boutique investment firm, with roots dating back to 1984 that manages a variety of portfolios primarily for US clients. Uniplan maintains a complete list and description of composites that is available upon request. 2. The composite was created August 1, 1999. Performance is calculated in US dollars utilizing a time-weighted total rate of return. Total return for the composite is represented by the asset-weighted returns of the portfolios within the composite. Trade-date valuation is used. 3. Gross performance is net of all transaction costs and net performance is net of transaction costs and investment management fees, but before any custodial fees. 4. The benchmark for the composite is the Wilshire US Micro Cap Index that represents a float-adjusted, market capitalization-weighted portfolio of all stocks below the 2,500th rank by market capitalization in the Wilshire 5000 at March 31 and September 30 of each year. The index is used to measure small stocks and is adjusted to reflect the reinvestment of dividends, when applicable. It is not possible to invest directly in an index. The index figures do not reflect any deduction for fees, expenses or taxes. 5. The dispersion of annual returns is measured by the standard deviation of asset-weighted portfolio returns represented within the composite for the full year. The standard deviation of the annual returns for the period August 1, 1999 to June 30th 2015 is 17.8% for the composite and 26.1% for the benchmark index. 6. The composite does not have a minimum size criterion for composite membership. All fee-paying discretionary accounts with similar investment objectives are included. Leverage is not used in this composite as a means to generate higher returns. There is one non-fee paying portfolio in the composite. 7. There have been no changes in the personnel responsible for the management of this composite. 8. The composite contains both traditional and wrap fee portfolios. Uniplan has a flexible and negotiable fee schedule reflecting the differences in size, composition and servicing needs of clients’ accounts. A complete description of investment advisory fees is contained in Uniplan’s Form ADV and is available upon request. 9. Individual account performance may vary from the results shown because of differences in inception date, restrictions and other factors. Past performance is no guarantee of future results. 10. Investors should understand that micro-cap stocks are subject to a higher degree of risk than other equity investments due to the small size of the companies and the limited trading volume inherent in micro-cap stocks.

Uniplan Investment Counsel, Inc. (Formerly known as Forward Uniplan Advisors) is a registered investment advisor. The views expressed contain certain forward-looking statements. Uniplan Investment Counsel believes these forward-looking statements to be reasonable, although they are forecasts and actual results may be meaningfully different. This material represents an assessment of the market at a particular time and is not a guarantee of future results. This information should not be relied upon by the reader as research or investment advice regarding any particular security. Past performance does not guarantee future results. Prices, quotes and other statistics have been obtained from sources we believe to be reliable, but Uniplan Investment Counsel cannot guarantee their accuracy or completeness. All expressions of opinion are subject to change without notice. It should not be assumed that recommendations made in the future will be profitable or will equal the performance of this security. A list of securities purchased and sold in the portfolio during the past year, including the purchase or sale price and the current market price, is available upon request by calling 262-534-3000.